Interactions Between Climate Change Policies And Tax System Addressed In RFF Issues Brief

June 05, 1997

WASHINGTON, DC -- Climate change polices that seek to reduce emissions of greenhouse gases are likely to aggravate distortions in the economy created by the tax system. However, most of this added cost can be offset if the policy raises revenue for the government and the revenues are then used to cut other taxes, according to a new issues brief published by Resources for the Future (RFF).

Authored by RFF's Ian Parry, the issues brief, Revenue Recycling and the Costs of Reducing Carbon Emissions, is part of RFF's series on key issues in the debate over global climate change. It is available on the internet at

"Reducing carbon emissions may produce important benefits in terms of avoiding future climate change," Parry says. "Nonetheless, it makes sense to consider which policy approaches might reach these objectives at the lowest economic cost. Recent research suggests that much may be at stake in this respect -- even the costs of modest reductions in emissions may differ substantially under different types of regulatory policies."

In his paper, Parry discusses the "double dividend" hypothesis -- that carbon taxes can reduce carbon emissions and reduce the overall costs of the tax system at the same time. He further explains why he thinks the hypothesis is invalid.

"The distinction between policy instruments that raise revenue and those that do not raise revenue can affect whether a policy might produce an overall net gain for society or not," Parry says. "The overall cost of policies to reduce carbon dioxide (CO2) emissions increases, perhaps substantially, if you take into account their impact on exacerbating the costs of other pre-existing taxes, such as social security taxes and corporate income taxes. However, most of this cost can be offset if the carbon abatement policy raises revenues and these revenues are used to reduce other taxes."

As decisionmakers prepare for domestic policy debates and the ongoing international negotiations under the Framework Convention on Climate Change, RFF's climate issues briefs provide topical, timely, and non-technical information and analysis. They are intended to integrate the various aspects of climate change with critical reviews of existing literature and original research at RFF on climate policy, energy markets, agriculture, water and forest resource management, technological change, air pollution, and sustainable development.

Key Terms

CLIMATE CHANGE can be caused by an increase in the atmospheric concentration of greenhouse gases which inhibits the transmission of some of the sun's energy from the earth's surface to outer space. These gases include carbon dioxide, water vapor, methane, chlorofluorocarbons (CFCs), and other chemicals. The increased concentrations of greenhouse gases result in part from human activity -- deforestation; the burning of fossil fuels such as gasoline, oil, coal and natural gas; and the release of CFCs from refrigerators, air conditioners, etc.

REVENUE-RAISING INSTRUMENTS include carbon taxes and emissions permits that are sold by the government. Carbon taxes discourage the use of fossil fuels and aim to reduce carbon dioxide (CO2) emissions by placing a surcharge on the carbon content of oil, coal, and gas. Alternatively, CO2 emissions may be reduced by requiring that firms have a permit for each unit of CO2 emitted. By controlling the total quantity of such permits available to electric utilities and other firms, the government can limit CO2 emissions to a target level. Allowing firms to trade permits amongst themselves affords them a lot of flexibility in achieving emissions reductions. Emissions permits are currently being used in the United States to regulate chlorofluorocarbons (CFCs) and to limit emissions of sulfur dioxide pollutants that cause acid rain.

NON-REVENUE-RAISING INSTRUMENTS include freely-allocated emissions permits, technology standards and emissions standards. The latter two policies are forms of command-and-control regulation where polluters are required to meet specific emission-reduction targets, and often requires the installation and use of specific types of equipment to reduce emissions.

The TAX-INTERACTION EFFECT is the spillover impact that environmental regulations have in markets that are already distorted by taxes. Personal and corporate taxes tend to reduce the overall level of employment and investment in the economy. Environmental regulations typically lead to some further reduction in employment and investment, thereby adding to the distortion created by the tax system. The cost of this effect is part of the overall cost of the regulation. For example, a tax on the carbon content of fossil fuels would drive up the cost of electricity and gasoline. Firms would most likely scale back their production activities in response to these higher costs, which would lead to a fall in investment and employment (this happened, for example, in the 1970s when the price of energy increased).

The REVENUE-RECYCLING EFFECT is the economic gain from using any revenues raised from environmental policies to reduce other taxes. This can offset most, but typically not all, of the cost from the tax-interaction effect.

Resources for the Future (RFF)

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